An Eye on Independent Contractors: IRS Examines Worker Classification in the Construction Industry

October 1, 2010

The Internal Revenue Service (IRS) has started a National Research Project to examine businesses’ practices of classifying workers as either employees or independent contractors. The agency is expected to check around 6,000 businesses, and the construction industry will get more than its share of scrutiny in the next 3 years.

While only a small percentage of U.S. businesses will be affected, this particular research program may be just the tip of the iceberg. Since the IRS published the updated “Construction Industry Audit Technique Guide” in June 2009, regular income tax audits of contractors have been on the rise. Add to that the complexity of construction tax law and the IRS’ current emphasis on the completed contract method of accounting, and the industry could be facing a perfect storm for IRS audits.

Other organizations have an interest in worker classification as well. The Department of Labor (DOL) wants to ensure workers and employers comply with the Fair Labor Standards Act and wage and hour laws. The DOL also is concerned with minimum wages, overtime, discrimination based on age or disability, medical leave, organizing, and
collective bargaining.

The Department of Health and Human Services has an interest in Medicare benefit payments for employees, and state agencies have concerns about unemployment taxes and benefits.

Most importantly, the misclassification of workers is viewed as a factor in the tax gap: the difference between the estimated actual taxes that should go to the U.S. Treasury annually in the form of employment and income taxes, and the amount that actually is paid on a timely basis. Workers who are misclassified and treated as independent contractors contributed an estimated $1.6 billion to the tax gap in the last IRS study, conducted more than 25 years ago. That figure is estimated to be significantly larger today.

Independent contractors can be easily employed, readily terminated, require less reporting and paperwork, and often are paid a smaller total compensation package compared to a similar employee. Workers frequently view the independent contractor status favorably because they can establish their own entities, set up their own pension plans, more effectively deduct tools and equipment, and lower their payroll taxes because their expenses are deducted before the self-employment tax calculation.

But earning that classification is not easy. In IRS case
history, it is nearly impossible to find an instance in which the IRS argues that an employee should be classified as an independent contractor—and not the reverse.

How Will the New Program Work?

The IRS audit program will start with the 941 form and work back to the employees and independent contractors for needed clarifications. It will look at classification as well as fringe benefits, non-filers, and officers’ compensation. All of these issues can be troublesome; if the IRS identifies problems in one area, it will certainly look at the others more closely.

Be aware that companies may not know why they are selected for an audit. The IRS has indicated it may look at companies that issued 1099 forms of $25,000 or more to five or more workers who reported no other income on their personal returns. Companies suspecting they have independent contractors working solely for them may want to examine the propriety of those worker-employer relationships.

Workers also may initiate an audit by filing an SS-4 form and an 8919 form (in which an individual claims he was an employee but that employment taxes were not withheld and paid) as a way to cut his taxes when he realizes he may owe more than he expected.

A Brief History

Congress included Section 530 in the Revenue Act of 1978 to address previous problems in which the IRS was charging employers for payroll taxes that the individuals also may have paid. Section 530 limited the power of the IRS to classify workers as employees if the employers could demonstrate a reasonable basis for treating the workers as independent contractors based on certain criteria. It also prevented the IRS from issuing regulations and rulings for worker classification. That law has not been updated since, and the IRS still operates under these restrictions.

Employers can submit an SS-8 form to the IRS for a determination of an employee, but the Government Accountability Office has determined that the IRS’ response to the form is frequently delayed and inconsistent. Also, many employers are hesitant to file this form, as it could trigger an audit.

In January 1987, the IRS issued Revenue Ruling 87-41, which listed 20 factors to consider for classifying a worker. None of the factors are controlling, and no weighting is assigned, so determinations with that ruling are still subjective. But, it added some considerations to the common law definition of an employee, which generally centers around how much an employer controls a worker.

In February 2009, the Treasury Inspector General for Tax Administration issued a report recommending a program to re-address the worker classification issue, and Congress introduced a handful of bills aimed at protecting the rights of workers while raising revenues for the Treasury.

Important Precautions

Not only can a company be randomly chosen for the IRS study, but an investigation into the company’s employment practices could be initiated when an independent contractor applies for unemployment compensation and discovers he was never classified as an employee.

A construction company also should be careful when paying for occasional “casual” labor: a non-business, non-routine service, such as refrigerator repair or grass cutting at a residence. Any further commitment may be considered domestic employment subject to payroll taxes.

Correcting a situation could cause a problem, too. For example, if a company determines that a worker previously categorized as an independent contractor should actually be an employee, issuing a W-2 and a 1099 form in the same year could be a red flag. If a worker is borderline, the best plan might be to strengthen his position as an independent contractor rather than switch him to employee status. While workers can have dual status by performing more than one type of task for compensation, it might be best to switch an employee at the beginning of the next year so that both a W-2 and a 1099 form are not issued to the same individual in the same year.

Although employees often cost the company more in payroll taxes and fringe benefits, some savings could be incurred. For example, independent contractors do not figure into the calculation of the Section 199 Domestic Production Activities Deduction (DPAD). Wages are a part of the calculation, but payments to independent contractors are not. A company may have a greater DPAD deduction with more employees and fewer independent contractors.

Because the exposure for misclassification is higher now than in the past, construction companies should operate as if they will be audited. Take account of all workers, the tasks they perform, and the process for determining the correct classification. Review the rules and the application of those rules on a regular basis. If a worker still falls into the independent contractor category, be sure to strengthen the worker-employer relationship and the supporting documentation so the independent contractor status is beyond question.

Companies also should ensure they have signed agreements with their independent contractors and that 1099 forms have been filed properly.
With a basic understanding of the issues and the rules—and strong documentation—any contractor can survive a worker classification audit.